How bonds can reduce risk in a stock market that is too hot

After a record-breaking stock market run, adding bonds to your portfolio is an easy way to profit

Here's how to approach it.

Despite the uncertain economic and geopolitical environment, stock markets continue to reach all-time highs. The initial public offering (IPO) of SpaceX last week, as well as the prospective IPOs of OpenAI, the company that owns ChatGPT, and its competitor Anthropic, have increased market euphoria.

The market's breadth, however, is at a record low. Almost all of this year's MSCI World performance has been attributed to a small number of AI-related brands. Furthermore, bumper initial public offerings (IPOs) have historically indicated a market peak.

In the current climate, some investors might wish to take a portion of their profits, limit their exposure to stocks, and resist the urge to trade while still holding onto their investments. One possible solution is to include some bonds in your portfolio.

Bond return using a 60/40 portfolio.

Between 2020 and 2024, a number of unfavorable events caused the conventional 60/40 portfolio60% stocks and 40% bondsto lose favor. Bonds hit new highs during the pandemic while central banks kept interest rates at or below zero. However, inflationwhich most investors had forgotten aboutreturned with a vengeance between 2022 and 2024. Bonds fell as interest rates rose. As a result, according to Morgan Stanley, a 60/40 portfolio of US stocks and bonds returned 17.3% in 2022its lowest performance since 1937.

However, we now live in a completely different setting. Investors don't have to give up much in return when purchasing high-grade corporate and government debt because yields are at some of the highest levels since 2007 (unlike 2020 and 2021). There is less chance that an abrupt increase in interest rates will cause a collapse akin to that of 2022 when starting yields are higher. Thus, a 60/40 or 80/20 asset allocation may once again seem reasonable in a frothier stock market. One cannot forecast the future. Nonetheless, historically, a 60/40 strategy has tended to provide strong volatility protection. According to Morgan Stanley, a 60/40 US portfolio grew at a compound annual growth rate of 7.3% from 200 years to 2024. Only sixteen times did stocks and bonds experience negative returns in a single year, demonstrating how exceptional 2022 truly was.

Lower long-term returns have resulted from investing in a combination of stocks and bonds as opposed to all stocks. According to a report for the CFA Institute, between 1901 and 2022, a global 60/40 portfolio would have returned 4 percent annually, an 80/20 portfolio would have returned 5 percent, and an all-stock portfolio would have returned about 6 percent. It should be noted that both the 60/40 and 80/20 portfolios had comparable risk-adjusted returns, or returns in relation to volatility. On the other hand, the risk-adjusted returns of a much more conservative portfolio consisting of 70% bonds and 30% stocks were lower. To put it another way, being more cautious continues to lower returns after a certain point but results in a more marginal reduction in risk.

All of this suggests that long-term investors should be cautious when determining their bond exposure. Lower returns are likely to result from overdoing it. Increasing exposure in volatile markets, however, may still make sense for a while.

How to modify the exposure to bonds.

Using a fund series like Vanguard LifeStrategy, which allows you to switch between 100 percent equity and 60 percent or 80 percent equity funds in a straightforward transaction, is one simple way to modify your bond weight. These funds, which have daily rebalancing and ongoing fees of 0.2 percent, are incredibly affordable. The HSBC Global Strategy fund series and the Fidelity Multi Asset Allocator are two additional options.

As an alternative, think about utilizing a variety of index funds or exchange-traded funds (ETFs), like Vanguard Global Aggregate Bond GBP Hedged (LSE: VAGS) and iShares MSCI ACWI ETF (LSE: SSAC) for international stocks. This enables you to change the stock and bond weight to suit your preferences.